Sunday, March 11, 2007

SUMMARY:
- Jobs report continues the rally . . . for the morning.
- Upward revisions keep the jobs report in decent shape.
- Who, or more precisely what, benefits from higher taxes.
- Still some great looking upside plays, but the market looks heavy heading into next week.

Jobs report gives the market what it wants but even that doesn't satisfy it.

After the Monday dump lower stocks fought back all week, rising to next resistance at the bottom of the November/December lateral range. It stalled at that point, but it was just waiting on the jobs report to either send it higher or choke off the rally. As it turns out the market pretty much got what it wanted when jobs came in at 97K (100K expected) with an upward revision to December and January. Lower yet higher. Weaker, but stronger as well. In a market still pondering the Fed's next move the dichotomy was nirvana-like.

The overseas markets were lower, but unlike the prior sessions when the US financial markets deferred to foreign direction, US stock futures surged on the jobs report, running 10 to 15 points above fair value. Looked promising, looked as if the jobs report was the juice to continue the rebound move and perhaps deliver a follow through to the Tuesday reversal.

Of course you always have to view a very strong open with skepticism, and the fact that the market has started a correction underlines the need for caution. On top of that the market spent the week rebounding from the spanking it took the prior week, a low volume rebound that indicated fewer and fewer upside participants. With the correction you knew the sellers were going to take a shot at the early bounce. It was just a matter of time.

That turned out to be at the open. Stocks opened higher but that was the high. Indeed the first leg lower was the sharpest of the day. The indices managed to hold onto positive ground and put in a midday bounce. When the sellers finished lunch they had dessert on the market, driving stocks into negative territory. It took a late session rebound to turn the indices back to positive, and even with that NASDAQ and NASDAQ 100 could not pull it off.

Problem is, they lost their strength after that first move. Volume was low and the indices could not hold the move through near resistance as leadership was scattered and sporadic. If you were looking for a follow through or at least a jobs-induced rally continuation you were disappointed with the marginal, low volume moves higher. As they say on the streets, all show and no blow (or vice versa; I don't know the streets too well).

In the end it was a day where neither the buyers nor the sellers could take the advantage. The market pitched back and forth a few times, but after a week that started sharply lower and then fought back on low volume, a low volume, flat on the close session was about all they had left.

The Technical Picture: Does it make sense this would be a bottom?

In the glow of the jobs-induced higher futures, some financial station journalist majors crowed how they had called the bottom on Tuesday. The resumption of the upside move on Thursday after the Wednesday stall combined with the Friday futures surge was enough proof for them. Of course the week itself in no way proved that hypothesis. Volume was lower each session as the indices climbed back up from the initial thumping. The rebound stalled at the first possible resistance, the 10 day EMA. Though the weekend influence can slow the Friday trade, the fact that the market could not make anything of the 'just right' jobs report other than a weak test of near resistance suggests a dearth of remaining buying interest.

That likely means the next phase of the down leg starts sometime this week given the indices are already struggling below resistance. Monday could still prove to be the bottom if the indices hold at that level and make a double bottom, but this is likely not any knifepoint turn or 'V' bottom. Indeed, there is likely two more pretty sharp downside legs before this correction finds its bottom.

Think of it this way: after a 7 month rally, is a week of sharp selling and a lower volume rebound enough to wring out the froth and set up another 7 month move? In the correction of '06 it took 10 weeks and 3 down legs to find the bottom before the indices found the bottom and started the final phase of the bottoming process. That rally that preceded that correction was 6 months (5 months from the breakout) and covered roughly 150 SP500 points.

The current rally lasted 7 months and covered 225 SP500 points in a much sharper ascent. Now the market doesn't make a habit of acting logically, but it is somewhat consistent in what it needs to decompress after long runs and set up for the next move. If it took 10+ weeks to shakeout a shorter and flatter rally, one week of selling is not going to do the trick on a longer and stronger run.

There might be more upside to this current relief bounce. They can last more than a week and this one is just a week old. The action to end the week, however, suggests it is running out of steam, and it is doing so at the earliest lower resistance level. That does not speak well of the upside conviction. Thus it behooves us to keep our upside stops fairly tight and be ready to play some more downside. Indeed we dabbled in some positions Friday with another dump lower in SBUX and taking an earlier and more aggressive position in some SPY puts. There are many more stock patterns indicating some more downside ahead, and we will cherry pick those that look to be in a hurry to move lower.

THE ECONOMY

Jobs continue steady pace as revisions continue to save the day.

The 100K jobs expected were no great shakes and were in line with the 111K reported in January. Thus when the payroll report slid in at 97K the market did not wince. Indeed, it responded favorably because once more the prior months were written higher. January was pushed up to 145K while December received another 20K boost. As noted above, weaker yet stronger. On top of that, the unemployment figure fell to 4.5% from the 4.6% it was expected to hold from January. What a bonus. The Fed is perceived not to pay much mind to the unemployment rate versus non-farm payrolls, so this was viewed by some as hidden strength in the report.

As we have seen, the household survey reflected in the unemployment percentage is the more accurate indicators for this recovery given the complete bust of so many businesses in the last recession, but you can be the Fed is not overlooking it. There are still those on the FOMC who subscribe to 'Phillips Curve Quarterly', and they view higher employment as inflationary. The PC's acceptance is strange given history debunks it. It is a theory said to apply to the economy as a general overlay for all economic periods, but ironically it only correctly tracks 6 years of economic history. Talk about the exception swallowing the rule.

As for the details, it was not a banner report. Construction lost 62K jobs due to bad weather and the continued slowing (or is it 'sucking'?) housing market. That was the largest decline since a January 1991 75K decline. Hmmm. Services gained a fat 168K jobs, but with the government portion rising 39K and the loss of construction workers, that left just 58K private sector jobs created when the average has been 180K. Government jobs provide nothing to the economy, at least nothing that really pays for itself. They are created with tax dollars and as discussed below that makes them a real drain on the economy. Government does not produce as much as the private sector, it is more wasteful, and thus we get less out of a government job than we do a private sector job. And the tax money it takes to create the job adds an additional burden on the economy in that the money is taken out of the system. The disposable income provided by the marginal government job in no way offsets the economic drain the jobs creates.

Why do we say 'hmmm' about the 1991 comparison? Because that was a time of recession in the US. Recall when we were starting to come out of the last recession we made comparisons to growth rates in the early 1980's when the US came out of that nasty 1970's depression? While so many were badmouthing the economy it was throwing off growth numbers in sector after sector that had not been seen since the recovery of the 1980's. Yes, that means they were better than the 1990's that so many wistfully pine for.

Comparisons on the upside are valid as they are on the downside as well. Of course you have to factor in all of the other variables in your analysis, and so far there is still a lot more strength right now than back in 1991 (that was in the actual recession). It pays, however, not to sweep these comparisons under the rug as some are doing. That is how you get blind sided. The economic data is definitely not as strong as it was in the first half of 2006. The long leading indicators still show accelerating growth, but the apple cart can be upset if mortgage issues grow and impact expectations, causing investors and consumers (business and individual) to pull back. Surprises can happen and thus we are keeping a close eye on this. We are not bearish on the economy by any stretch but we are not as comfortable with it as we were a quarter ago.

Hey, let's raise taxes and cover all of our expenses. What a bad idea.

Despite all of the rhetoric in the election run up about tax hiking as the last resort, there has not been one dime of proposed spending cuts and already there are plans in committees to raise taxes though they are veiled behind claims of eliminating the AMT. Well, some of them are not even veiled. Seems the list of possible actions was rather short with the last resort being choice number 2 (maybe even choice number 1).

It is easy for some to rationalize raising taxes. First, they harp about the deficit, saying it is the largest ever and is going to be a burden on future generations. It is not the largest ever in real, inflation adjusted dollars. As a part of GDP it is running at to below historical averages. It is the household mortgage analogy we used last week: if you make more money you can have a bigger mortgage and it is the same or even a smaller percent of your income than a lower mortgage at a lower income level. In other words, the economy is so much larger now it can afford a higher deficit in dollar terms.

There is also the idea that if you have a $50B shortfall you can simply raise taxes by $50B and solve your problems. Without even considering how Congress will squander most of any gain on pork barrel projects or new useless programs, the reality behind the impact of tax hikes on citizens and how much is actually collected undermines this simpleton belief.

An oft-cited recent report on the effects of tax cuts and tax hikes is being used to purportedly debunk the benefits of tax cuts. Those using it, however, fail to read the entire report that shows tax hikes are much more damaging to the economy and to US citizens. If you raise taxes on dividends by $1 the Treasury gets just $0.50. At the same time it costs the average citizen $2 in lost income plus the additional tax paid. If you raise taxes on all forms of income the Treasury does better with $0.77 per $1 tax increase.

So if you want to raise $50B in tax revenue you have to increase the tax even more, and the net cost to the US citizen is $2.25 to $5.00 in taxes and lost income as a result of decreased economic activity due to the tax. Sure the government gets its $50B, but you and I lose in the form of lower wages, no job creation, or worse the loss of jobs. In other words, there is a loss to citizens above the tax paid in the form of simply lost income through lost wages, salaries and other income. The kicker is this additional burden does not fall on just the rich as the tax proponents claim. It hits the middle and low income the hardest because it is their incomes that fail to rise or fall, it is their jobs that are lost or are not created at all. That means even the lowest end who pay no income taxes are hurt as well because their job may simply disappear or not even be created due to slower economic activity.

The only beneficiary of such a tax is a growing, bloated federal government that gets another huge chunk of money to spend. They sell it by saying they are taxing only the rich, but that money they collect comes at the cost to all citizens far in excess of the extra tax paid. Sure you may not be hit with the direct tax, but is that much comfort if you don't have a job because the additional tax money kept a business from creating another position? How about if you don't get a raise because of the tax?

It is easy to sell a tax hike on the 'rich' because most can understandably only see what appear to be the direct links: raise taxes on the higher incomes and those higher incomes pay the tax and they bear the burden. The empirical evidence, however, shows that the cost of the tax is passed down to all members of society through slower economic growth, fewer jobs, lower wages, etc. Higher taxes divert money to tax shelters, taking it out of the economy. That makes it harder for government to collect and results in more taxes to try and cover the 'tax gap.' It gets worse and worse as we saw in the 1970's, and the result is an incredibly convoluted and inefficient tax code that costs the economy $500B per year just in determining what tax is owed.

If they want to get serious about helping the economy and all citizens, then congress should seriously consider scrapping the IRS and going to a flat tax or a national sales tax. While both have their limitations (they are, after all taxes) they are infinitely better than what we have IF we totally scrap the income tax AND IF the rate is reasonable and not the absolutely absurd 24% to 35% levels we heard from the 'blue ribbon' tax commission. Let's face it, with people such as Heinz-Kerry worth hundreds of millions paying a net tax rate of just 12.5%, there is no way a flat tax will receive any support unless it is at that level. Given the absolute economic boom such a tax rate would create, however, the Treasury would be in the green inside 10 years, not just eliminating the yearly deficit, but the accumulated deficit as well.